Risky business: The government is encouraging subprime home lending

Policymakers concerned about inequality should look no further than federal housing finance policies that continue to target America’s working-class families and communities with risky lending practices. New research by the American Enterprise Institute’s International Center on Housing Risk indicates a concentration of high risk lending insured by the Federal Housing Administration in low-income states. Under economic stress, these homeowners and geographies would suffer from high levels of default and foreclosure. As the country’s housing market attempts to stabilize after the recent financial crises, policymakers have not taken the necessary steps to promote long-term stability in the mortgage markets, particularly in areas with high concentrations of low-income borrowers. The focus of federal housing finance policies should be on building stable equity for low-income borrowers rather than placing them at risk for default in a down market.

The center’s research brings into question efforts by the Consumer Financial Protection Bureau to “prevent consumers from getting trapped in mortgages that they cannot afford” through the promulgation of its “ability to repay rule.” The rule, which went into effect on Jan. 10, 2014, grandfathers precarious underwriting standards still in use by FHA and the Department of Agriculture’s Rural Housing Service, and government sponsored enterprises Fannie Mae and Freddie Mac until January 2021. Under the rule, loans backed by Fannie, Freddie and government agencies are considered “qualified mortgages” even if the borrower has a pre-tax total debt-to-income ratio that exceeds the 43 percent limit set in the regulations. Moreover, the rule prescribes no minimum credit score or minimum down payment. In January alone, 44 percent of FHA loans had a debt to income ratio above 43 percent combined with a down payment of less than 5 percent. Fifteen percent of Fannie and Freddie loans issued in January also exceeded a 43 percent debt to income ratio.

FHA risks repeating an all too familiar cycle: By encouraging increased leverage, house prices will begin to inflate, making housing less affordable, which leads to a further loosening of credit standards that feeds the next housing boom. Inevitably, prices will collapse, leaving the most vulnerable borrowers least able to cope.

AEI’s new research shows that the level of mortgage risk is on the rise. The center publishes monthly national and state indices measuring how newly originated loans would perform under the severely stressed conditions produced by a repeat of the recent financial crisis. Analogous to crash tests for automobiles, the center’s mortgage risk indices test how newly originated loans would perform in the equivalent of a severe crash. The indices currently cover home purchase loans that either have been securitized by Fannie and Freddie or have been guaranteed by the FHA or the Rural Housing Service. These loans account for about three-quarters of all home purchase originations in today’s market.

The mortgage risk index for the nation as a whole averaged more than 11 percent over the latest three months (November 2013 to January 2014), meaning that roughly one in nine newly originated government-backed mortgages would fail if the country underwent another financial crisis like the one that began in 2007. Defaults on this scale would impose a huge cost on taxpayers, and the associated foreclosures would severely harm surrounding neighborhoods. Much of the problem can be laid at the doorstep of the FHA, which has become a large-scale subprime lender run by the federal government.

The state-level indices show that the level of risk varies widely by state, with the stressed default rate in the highest-risk state (Mississippi) more than double that in the lowest-risk state (Hawaii). The presence of Mississippi at the top of the risk ranking hints at a broader pattern in the data: The mortgage defaults induced by another financial crisis would hurt low-income states the most. Of the 10 states with the lowest median household incomes in the country, as ranked by the U.S. Census Bureau’s Current Population Survey, six of those states (Mississippi, Louisiana, West Virginia, Alabama, Arkansas, and Kentucky) can also be found on the top 10 list for the stressed default rate. Should the United States experience another severe financial crisis, nearly one in six newly issued government-backed mortgages in Mississippi would potentially default, disproportionately harming this low-income state.

The ability to repay rule provides a false sense of security for Americans looking to purchase a home. With no down payment or credit score requirements and loose debt to income requirements, low and moderate-income families will continue to be placed into risky loans they can’t afford. For example, an FHA borrower earning $40,000 pre-tax with annual debt payments of $17,200 (43 percent of income) would be able to purchase a home for $175,000, more than four times their annual income. Policy makers should consider the advice of Martin Luther King in his “The Drum Major Instinct” sermon, which highlighted the downside of buying more house than one can afford: “Get[ting] a check every month somewhere, and owe all of that out before it comes in. Never have anything to put away for rainy days.” The residents of our low-income states deserve better than a path towards homeownership with illusory guardrails.

Emily E. Rapp is a financial policy researcher at the American Enterprise Institute.